Online Extra: Shopping for Growth in New Places

While tech alone won't do anymore, dogged investors will find plenty of alternatives

December 31, 2001, 12:00 AM EST

For many investors, buying technology stocks used to be synonymous with loading up on growth stocks -- issues from companies with rapidly rising earnings. That strategy worked well all during the tech boom. But then came the dark days of the bust.

Beginning in spring 2000, tech stocks took a tumble that's just beginning to reverse. Despite a rebound in the waning months of 2001, the tech-heavy Nasdaq Composite index will end the year off about 20%. And through Dec. 6, according to Morningstar, mutual funds with a growth focus had performed abysmally, losing 18% since January. That compares with gains of 54% for growth-focused funds in 1999, and an 8% decline in 2000.

Growth stocks were so out of style in 2001 that they trailed even value stocks -- issues priced low, often because of weak earnings. Through Dec. 6, value funds had gained 0.61% for the year, after an 11% gain in 2000 and a 7% rise in 1999.

"TOO FIXATED."

So the question arises: If you're a growth-oriented investor, what should your plan be for 2002? True, an improved economy will probably boost tech stocks once again. Still, few fund managers are banking on a sudden resumption of the tech boom. "Everyone is way too fixated on technology," declares Robert Smith, fund manager at T. Rowe Price's large-cap Growth Stock Fund. "It's a decent growth business, but very cyclical."

And probably already overpriced, given the Nasdaq's yearend run. Paying 50 or 60 times earnings for a tech stock is a hefty price when the earnings-growth rate could be anywhere between 10% and 35%, Smith says. Add in the uncertain timing of the economic recovery, he notes, and it might make more sense to buy a stock like Home Depot (HD
): It trades at about 40 times earnings, and the company aims to increase profits by 18% to 20% per year.

Indeed, growth investors should be thinking diversification, says Angela Auchey Kohler, manager of Federated Investors' Large Cap Growth Fund. Outside of tech -- which she still intends to buy -- Kohler is looking to the health-care and energy sectors. Medical-device stocks should continue to do well this year, as the industry prepares to introduce several new products, such as drug-coated stents to prevent cleaned-out arteries from reclogging. Kohler also likes large-cap pharmaceutical companies, which didn't fare well in 2001 but are "starting to get intriguing" at current prices.

WARMER ENERGY.

The hiring of a new Food & Drug Administration commissioner sometime in 2002 should also help drug stocks. Several key drug-review posts are currently vacant, which has caused delays in the review process. Once these jobs are filled, companies are likely to see faster drug approvals and therefore less pressure on stocks.

When it comes to energy, Kohler is betting on rising prices, as Russia and OPEC cut oil output. That would be good for oil-services stocks, she says, especially since "a stronger economy means higher [industrial] production and more demand for oil." Kohler owns oil-services companies Baker Hughes (BHI
), Transocean Sedco Forex (RIG
), and BJ Services (BJS
).

Whatever the growth stocks of choice may be, they're likely to produce relatively modest profit gains in 2002, compared with the multidigit percentage growth common in the late '90s. As Eric Leo of Allied Investment Advisors begins a shift into higher-growth stocks from lower-growth holdings, he's looking for companies with annual earnings gains of 10% to 15%. "That's the area a lot of the growth managers overlook," Leo says, because they're in search of the biggest returns.

AFTER ENRON.

Leo thinks it's smart in a struggling economy to look for earnings consistency rather than meteoric increases. "Some think that former high-flyers will get back to their old levels of performance," he says. "Those expectations will get recalibrated. Some companies won't [return to strong growth] until 2003."

Among the best picks Leo sees are companies poised to take over Enron's share of the energy-trading business. He expects low double-digit earnings growth over the next several years from the likes of Dynegy (DYN
), El Paso (EPG
), and Duke Energy (DUK
). Homebuilders, buttressed by consolidation, should also turn in strong results, Leo says. He expects annual profit growth in excess of 12% over the next several years from Centex (CTX
) and Toll Brothers (TOL
).

He also expects earnings growth at the food companies in the low to mid teens range. Even Kraft (KFT
), which was recently spun off from Philip Morris, looks like an interesting opportunity, Leo adds.

VALUE PLAYS.

Another way to play the growth game is to look for companies whose earnings are indicative of growth stocks but whose share prices are still in value-stock territory. Mike Farrell, portfolio manager and strategist at investment advisers David L. Babson & Co. in Cambridge, Mass., picks stocks that are cheap based on their historical growth rates.

Consider alternative power-generation companies. As a group, their earnings have grown by 48% annually over the past five years, but Farrell figures that the market is pricing these stocks as though earnings were rising about 7% a year. Like several other fund managers, he also sees big gains ahead in the earnings -- and stocks -- of homebuilders, oil refiners, and medical distributors, as well as for casino and gaming companies.

One technology arena might produce strong earnings growth: Small- and mid-cap tech stocks, says Mark Genovise, portfolio manager for Chicago-based Driehaus Capital's small-cap growth portfolio. That's because they're typically coming off a lower base. "Smaller companies can grow faster. There are more market inefficiencies that we can exploit," says Genovise. For example, he's looking for 50% growth in earnings over the next year at Genesis Microchip (GNSS
), a maker of flat-panel computer screens.

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The sexy technologies that captured Wall Street's imagination during the 1990s' bull run -- the Internet, wireless, and broadband -- are sure to keep grabbing attention from investors. "We think there's still growth [in tech stocks]," Allied Investment's Leo says. "But it may not be as high as the optimists think." So for now, the best strategy might be a portfolio that includes not only a few select tech companies but also winners in other sectors considered wallflowers during the tech boom.